Wednesday, November 16, 2011

Harry Dent is an American economist who predicted the Global Financial Crisis presents his new book "The Great Crash Ahead" (co-authored with HS Dent President Rodney Johnson) .He is the Founder and President of the H. S. Dent Foundation, whose mission is “Helping People Understand Change”. Using exciting new research developed from years of hands-on business experience, Mr. Dent offers a refreshingly positive and understandable view of the future. Harry S. Dent Jr. is one of the smartest, savviest economic researchers around, and his track record for being RIGHT when conventional wisdom has been wrong cannot be ignored.Harry Dent shares his view on which asset classes you should invest in and which you should avoid. If you want to make sure you have all your financial bases covered in the months and years ahead, you owe it to yourself to hear what he has to say.

If having a Diet Coke from Coca-Cola (NYSE:KO) is on the tip of your tongue the next time a waiter or waitress asks you what you'd like to drink with a meal, you may be quickly offered a Diet Pepsi from PepsiCo (NYSE:PEP) instead. Personal preferences aside, beverage providers can offer stability to an otherwise volatile portfolio. Let's take a look at why soft drink producer stocks are looking like a refreshing choice over financials and automotives.

Smoothed by BetaA stock's beta relates to how it responds to the up and down swings of the overall stock market as measured by a broad index like the S&P 500 Index. A stock with beta of 1 suggests that a 5% increase or decrease in the S&P 500, or a tracking investment like the SPDRS S&P 500 Index ETF (NYSE:SPY), will translate into a nearly identical move by the stock. Likewise, a stock with a lower beta, let's say 0.5, may only move up and down half as much as a stock with a beta of 1. (For related reading, check out Beta: Know The Risk.)

Pepsi's Beta ChallengePepsi's stock has gained -1.9% since the beginning of the year, while the SPY ETF has moved just above -0.76% over the same time frame. Although Pepsi is not performing as well as SPY over this brief period of time, long-term investors who have been invested over the past five years do have reason to cheer.

Pepsi's stock from November 2006 until November 2011 has gained about 3.5%, while the SPY ETF lost 10.2% of its value over the same time frame. Although beta is not a golden rule for determining the volatile nature of a stock, it is a starting point for investors as they begin conducting their own research. (For more, see Beta: Gauging Price Fluctuations.)

Coke's Beta BufferIn a similar fashion Coke, with its beta of 0.42, has gained around 4.3% since the beginning of the year. Most impressively, Coca-Cola has gained 43.9% since 5 years ago.

Not So SimilarFor further comparison in the soft drink industry, investors can also take note of Dr Pepper Snapple Group (NYSE:DPS). Dr Pepper Snapple has a beta of 0.74 and its stock has increased more than 45.7% since it started trading in May 2008; it has already surge over 3.4% year to date.

Final ThoughtsA portfolio with heavy doses of financial services like Citigroup (NYSE:C) or automotive companies like Ford (NYSE:F) are exposed to stocks with relatively high beta ratios of 3.11 and 2.28 respectively. Investing in soft drink industry players is less likely to take the fizz out of your portfolio, but may smooth the ride for portfolios in need of an individual stock beta checkup.

Home Depot (NYSE:HD) – This home improvement retailer rose from under $28 to over $38 since August, based on excellent Q2 earnings of 86 cents versus a consensus of 83 cents. Higher gross profit margins and better expense leverage contributed to the quarterly success.

HD reported Q3 earnings this morning of 60 cents versus an estimate of 58 cents. Same-store sales were up 4.2% versus a 3.8% estimate, and the company raised its full-year estimated earnings to $2.38 from $2.34. It also increased its dividend by 4 cents per quarter to $1.16 for a current 3% dividend yield.

There are two prices that are critical for any investor to know: the current price of the investment he or she owns, or plans to own, and its future selling price. Despite this, investors are constantly reviewing past pricing history and using it to influence their future investment decisions. Some investors won't buy a stock or index that has risen too sharply, because they assume that it's due for a correction, while other investors avoid a falling stock, because they fear that it will continue to deteriorate.

Does academic evidence support these types of predictions, based on recent pricing? In this article, we'll look at four different views of the market and learn more about the associated academic research that supports each view. The conclusions will help you better understand how the market functions, and perhaps eliminate some of your own biases.

Momentum"Don't fight the tape." This widely quoted piece of stock market wisdom warns investors not to get in the way of market trends. The assumption is that the best bet about market movements is that they will continue in the same direction. This concept has is roots in behavioral finance. With so many stocks to choose from, why would investors keep their money in a stock that's falling, as opposed to one that's climbing? It's classic fear and greed.

Studies have found that mutual fund inflows are positively correlated with market returns. Momentum plays a part in the decision to invest and when more people invest, the market goes up, encouraging even more people to buy. It's a positive feedback loop.

A 1993 study by Narasimhan Jagadeesh and Sheridan Titman, "Returns to Buying Winners and Selling Losers," suggests that individual stocks have momentum. They found that stocks that have performed well during the past few months, are more likely to continue their outperformance next month. The inverse also applies; stocks that have performed poorly, are more likely to continue their poor performance.

However, this study only looked ahead a single month. Over longer periods, the momentum effect appears to reverse. According to a 1985 study by Werner DeBondt and Richard Thaler, "Does the Stock Market Overreact?" stocks that have performed well in the past three to five years are more likely to underperform the market in the next three to five years and vice versa. This suggests that something else is going on: mean reversion.

Mean ReversionExperienced investors who have seen many market ups and downs, often take the view that the market will even out, over time. Historically high market prices often discourage these investors from investing, while historically low prices may represent an opportunity.

The tendency of a variable, such as a stock price, to converge on an average value over time is called mean reversion. The phenomenon has been found in several economic indicators, including exchange rates, gross domestic product (GDP) growth, interest rates and unemployment. Mean reversion may also be responsible for business cycles.

The research is still inconclusive about whether stock prices revert to the mean. Some studies show mean reversion in some data sets over some periods, but many others do not. For example, in 2000, Ronald Balvers, Yangru Wu and Erik Gilliland found some evidence of mean reversion over long investment horizons, in the relative stock index prices of 18 countries, which they described in the "Journal of Finance."

However, even they weren't completely convinced, as they wrote in their study, "A serious obstacle in detecting mean reversion is the absence of reliable long-term series, especially because mean-reversion, if it exists, is thought to be slow and can only be picked up over long horizons."

Given that academia has access to at least 80 years of stock market research, this suggests that if the market does have a tendency to mean revert, it is a phenomenon that happens slowly and almost imperceptibly, over many years or even decades.

MartingalesAnother possibility is that past returns just don't matter. In 1965, Paul Samuelson studied market returns and found that past pricing trends had no effect on future prices and reasoned that in an efficient market, there should be no such effect. His conclusion was that market prices are martingales.

A martingale is a mathematical series in which the best prediction for the next number is the current number. The concept is used in probability theory, to estimate the results of random motion. For example, suppose that you have $50 and bet it all on a coin toss. How much money will you have after the toss? You may have $100 or you may have $0 after the toss, but statistically the best prediction is $50; your original starting position. The prediction of your fortunes after the toss is a martingale.

In stock option pricing, stock market returns could be assumed to be martingales. According to this theory, the valuation of the option does not depend on the past pricing trend, or on any estimate of future price trends. The current price and the estimated volatility are the only stock-specific inputs.

A martingale in which the next number is more likely to be higher, is known as a sub-martingale. In popular literature, this motion is known as a random walk with upward drift. This description is consistent with the more than 80 years of stock market pricing history. Despite many short-term reversals, the overall trend has been consistently higher.

If stock returns are essentially random, the best prediction for tomorrow's market price is simply today's price, plus a very small increase. Rather than focusing on past trends and looking for possible momentum or mean reversion, investors should instead concentrate on managing the risk inherent in their volatile investments.

The Search for ValueValue investors purchase stock cheaply and expect to be rewarded later. Their hope is that an inefficient market has underpriced the stock, but that the price will adjust over time. The question is does this happen and why would an inefficient market make this adjustment?

Research suggests that this mispricing and readjustment consistently happens, although it presents very little evidence for why it happens.

In 1964, Gene Fama and Ken French studied decades of stock market history and developed the three-factor model to explain stock market prices. The most significant factor in explaining future price returns was valuation, as measured by the price-to-book ratio. Stocks with low price-to-book ratios delivered significantly better returns than other stocks.

Valuation ratios tend to move in the same direction and in 1977, Sanjoy Basu found similar results for stocks with low price-earnings (P/E) ratios. Since then, the same effect has been found in many other studies across dozens of markets.

However, studies have not explained why the market is consistently mispricing these "value" stocks and then adjusting later. The only conclusion that could be drawn is that these stocks have extra risk, for which investors demand additional compensation.

Price is the driver of the valuation ratios, therefore, the findings do support the idea of a mean-reverting stock market. As prices climb, the valuation ratios get higher and, as a result, future predicted returns are lower. However, the market P/E ratio has fluctuated widely over time and has never been a consistent buy or sell signal.

The Bottom LineEven after decades of study by the brightest minds in finance, there are no solid answers. The only conclusion that can be drawn is that there may be some momentum effects, in the short term, and a weak mean reversion effect, in the long term.

The current price is a key component of valuation ratios such as P/B and P/E, that have been shown to have some predictive power on the future returns of a stock. However, these ratios should not be viewed as specific buy and sell signals, just factors that have been shown to play a role in increasing or reducing the expected long-term return.

The new La Niña that is developing in the Pacific will have the impact of a strong event. Expect North America to have another cold winter.

You’ve seen the headlines. The Northeast was hit by a Nor’easter snowstorm that affected 60 million people. Over three million were left without power and outages to last for days. New York City received its earliest inch of snow since the Civil War. Pennsylvania, Washington DC and the entire Northeast were buried in as much as two feet of snow and then hit by freezing weather.

The Northeast is not the only cold area. Even Texas, already drought-stricken, had snow this month in Amarillo. The Rocky Mountains, including my home 300 miles from the Mexican border, has been buried in white stuff two times in October. Sunny California started the month with heavy rain in the Fresno valley (hammering the drying raisin crop) and snow for the ski resorts in the Sierra Nevadas. And it is all due to hot water and cold, cold air.

We are being hit by a La Niña and a “wild card”. Welcome to the early beginning of the winter of 2011/2012.

The Official Forecast

On October 20, the U.S. Climate Prediction Center issued its outlook for the winter of 2011/2012. It focused on the recent arrival of a new La Niña in the tropical Pacific and the impact of that phenomenon on American weather. However, it warned that the frozen polar air of the Arctic Oscillation could be a “wild card”. Let’s look at this prediction.

The government forecasters see a schizophrenic winter. According to the annual Winter Outlook released by NOAA the Southern Plains will continue to be warmer and drier than normal, while the Pacific Northwest will be colder and wetter than average. From December through February, the entire southern tier of states will have below normal precipitation, while the northern states will have above normal snow from the Pacific through the Great Lakes. The same northern region and the West Coast will have below normal temperatures. Meanwhile, the Mid-Atlantic States and the Northeast will be near normal. After last winter’s blizzards, the forecast will be a relief to New York and Pennsylvania.

The forecast warns that the major “wild card” in this projection is the Arctic Oscillation. In the NOAA’s words:

The Arctic Oscillation is always present and fluctuates between positive and negative phases. The negative phase of the Arctic Oscillation pushes cold air into the U.S. from Canada. The Arctic Oscillation went strongly negative at times the last two winters, causing outbreaks of cold and snowy conditions in the U.S. such as the “Snowmaggedon” storm of 2009. Strong Arctic Oscillation episodes typically last a few weeks and are difficult to predict more than one to two weeks in advance.

The Browning Newsletter agrees with much of this analysis. The La Niña in the Tropical Pacific will be a dominant factor shaping this winters weather. However, we routinely include other factors, some of which will trigger the “Wild Card” Arctic Oscillation to plunge abnormally far south for a third year in a row.

The La Niña Factor

Last year, one of the major factors that created last year’s cold winter in North America was a strong La Niña.

This year’s La Niña will be stronger!

A La Niña is when the Tropical Pacific is 0.5˚C (0.9˚F) cooler than normal. A moderate La Niña is around 1.0˚C (1.8˚F) and a strong event is 1.5˚C (2.7˚F) cooler than average. Last year the La Niña hovered between 1.5˚ and 2.0˚C (2.7˚ − 3.6˚F) all winter long. It began to weaken in January and was officially gone by June.

The Tropical Pacific began to cool again in late August and by mid-September, officials declared a La Niña condition.

It will have to continue for 5 weeks in a row to officially be declared a La Niña event. As Figure 6 shows, water temperatures can flicker into warm El Niño or cool La Niña territory. However if it doesn’t last for multiple months, then there is no long-term significant impact on climate.

What is the impact of the current La Niña?

The strong La Niña traditionally strengthens the South Asian monsoon. This has caused the massive flooding in Thailand. The event both strengthened and prolonged the nation’s wet season, causing the worst flooding in 50 years.

These floods are going to have a major global economic impact. Southeast Asia is the main source of rice exports. According to the October 25th edition of the Wall Street Journal, Thailand has had 12.5% of its total rice farmlands damaged in Thailand alone. In Cambodia, 12% of paddy fields have been destroyed, with another 7.5% in Laos and 6% in the Philippines.

Additionally, Thailand manufactures one-fourth of the world’s hard drives and half of the HDD for PCs. The floods have shut down more than 14,000 factories and forced at least 660,000 people out of work.

Closer to home, the return of La Niña has prolonged the drought in the Southern US. 100% of Texas, more than 85% of the South Central states and more than 53% of the Southeastern states are in drought. Ranchers are cutting back their herds across the Southern Plains. While in the short run this will reduce beef prices, it will take years for the herds to recover. Prepare for the price of your hamburger to rise.

The combination of a hot Atlantic and cold La Niña waters in the East Pacific coastline, sets up a pattern of winds that tend to steer tropical Atlantic storms straight into Mexico/Central America or up the middle of the Atlantic. This steers the storms away from the US oil and gas production fields in the Gulf of Mexico. During the short intermission between the last La Niña and this one, Irene ripped up the Atlantic Coast and TS Lee shut down more than 60% of the Gulf ’s oil production and 40% of gas production.

Going back to Asia – the summer disappearance of La Niña allowed Northern China to have an excellent corn crop. The reappearance of La Niña is creating wet harvest conditions for huge areas of the crop. Since China lacks an efficient, nationwide cold storage transportation network, the result will be high spoilage rates and poor quality for those goods finding their way to market. Last year’s autumn La Niña created some of the same difficulties including disease and vomitoxin in feed, have still not fully been resolved. China is still catching up on grain supplies. This return of the phenomenon will increase the nation’s problem, and we will see the problem become more severe through winter into spring.

Currently scientists are divided on how strong this event will grow. There is a consensus that this episode will last into spring. Initially most models projected a weak event but the majority now forecast a moderate event. Figure 8 shows the wide diversity of international opinions while Figure 9 shows NOAA’s Climate Forecast system’s models which have one of the best forecast records. Notice, the CFS model thinks the upcoming La Niña will be stronger than the one last year!

Here’s the main point. El Niños and La Niñas are the water temperatures. The associated air/weather pattern is called the Southern Oscillation. The severity of the water change and the associated weather usually go hand-in-hand, but not always. Two events are going to enhance the strength of the Southern Oscillation. The first is that the Northern Pacific is undergoing a cool phase of the Pacific Decadal Oscillation. The PDO will be discussed more in the next article, but it magnifies the weather impact of La Nina. The other event is that we will be having "volcano weather", increased winter cooling from the effects of two Artic volcano explosions this year.

In short, even if the La Nina is only moderate, it will have the global impact of a strong event!

The Outlook for Winter

Consider the early, record-breaking snowfall this year a warning. This will be a winter of Nor’easters. It will be a winter of blizzards. There is a lot of volcanic dust in the polar air mass and the “wild card” negative Arctic Oscillation will carry it south. It will collect moisture and fall out in blizzards.

There have been very few years like this year, but the most similar years had the following weather patterns:

LATE AUTUMN — The cool weather will continue to dominate the West Coast as autumn ends. The Northwest and western Canada should experience an early onset of winter with cool, stormy weather. Meanwhile, in 60% of similar years, the Northeast has a cool, wet late autumn. Temperatures will be warmer than normal in the center of the continent.

EARLY WINTER — Early winter is when the weather really starts to get chaotic. Cool western weather will crash into warm Southeastern weather and the Central Plains, Midwest and Northeast will endure storm after storm. Meanwhile in 80% of similar years, Western Canada and the Pacific Northwest have heavy snows and coastal rains. In 60% of similar years, the storm track surges further south, leaving large portions of Canada warmer than normal.

MID-WINTER — Mid winter can be described in two words – cold & stormy. Normally the South is dry, but the larger this winter’s La Niña is, the more likely it will be that there will be rain in the central and western Gulf States. Unfortunately in all 5 similar years, Texas, Georgia and parts of the Southeast suffered severe drought.

The outlook for this winter can be summed up in one phrase − Every natural factor that shaped the last year’s cold winter is back. Winter will not be an exact duplicate, but typically years with extremely similar factors have a roughly 70% similarity. Think what you should have done last winter and do it now.

I am on record as calling the U.S. stock market a buy in September when Robert Shiller’s PE10 (S&P 500 expressed as a ratio to the average trailing earnings of the past ten years) dropped below 20 and presented value. The PE10 briefly fell to 18.5 on the first trading day of October but the 12.8% rally in the S&P 500 has taken the gauge to 20.7 currently. That compares to the historical average of 16.4 times since 1881 and the low of 13.3 times during the great financial crisis of 2008/2009.

Sources: Robert Shiller; Plexus Asset Management.

The rating of the S&P 500 as measured by the earnings yield (inverse of PE10) improved as the anxiety levels in financial markets as measured by the CBOE S&P 500 Volatility Index (or VIX) eased from crisis levels.

Sources: Robert Shiller; Plexus Asset Management.

Anxiety levels remain elevated, though as the VIX is approaching crisis levels again. Since 19 October a significant gap has opened between the PE10 and the VIX where the current level of the VIX is calling for a PE10 of 20.0 compared to the current 20.7. It therefore implies that unless the VIX drops to 28, the S&P 500 could get a haircut of 3%. Please note that the following graph illustrates the daily values I calculate for the PE10 and that the VIX is on a reverse scale.

Sources: Robert Shiller; CBOE; I-Net Bridge; Plexus Asset Management.

In the past I have referred to the relationship between the Conference Board’s Consumer Confidence Index and PE10 as the former is an excellent indicator of the valuation of the U.S. stock market with regard to the state of the underlying economy.

At this stage the PE10 and consumer confidence have parted ways, with the former rising and the latter falling.

Decoupling? No, I do not think so. There are times when consumer confidence leads and times when the PE10 leads. Obviously, when the stock market rallies, consumers are more at ease as they feel wealthier (or less poor) and their confidence improves. What the PE10 is telling me is that the market is probably anticipating a huge rise in consumer confidence to in excess of 60, with the current PE10 one standard deviation above what the historical relationship implies.

The recent surge in stock prices will go a long way to restoring some confidence but I doubt whether 60 is within reach in the short term.

The reason why consumer confidence is so important is the fact that it is a determining factor in the velocity of money in the economy or the rate at which money is exchanged from one transaction to another.

Sources: FRED; Dismal Scientist; Plexus Asset Management.

Currently the level of the Consumer Confidence Index correctly reflects the velocity of money with zero maturity (MZM that includes notes and coins in circulation and cash or near-cash deposits of financial institutions).

Sources: FRED; Dismal Scientist; Plexus Asset Management.

A rise in the Conference Board’s Consumer Confidence Index to 60 implies that MZM velocity should rise to 1.57 from the current 1.46. A jump to 1.57 in MZM velocity would mean the year-on-year growth in GDP (in current money terms) has accelerated by 11% or 7.85% from the third quarter. You will agree that such acceleration is highly unlikely.

Sources: FRED; Dismal Scientist; Plexus Asset Management.

The bond market indicates that we should rather expect MZM velocity closer to 1.40 compared to the current 1.46.

Sources: FRED; I-Net Bridge; Plexus Asset Management.

MZM velocity of 1.57 as suggested by the market via PE10 implies a yield of close to 3% on the 10-year Government Bond Index. Again you will agree with me that this is highly unlikely in the short term.

Sources: FRED; I-Net Bridge; Plexus Asset Management.

Although volatile, the yield on the 10-year note has always been an excellent indicator and anticipator of underlying consumer sentiment.

Sources: I-Net Bridge; Dismal Scientist; Plexus Asset Management.

The 10-year note is currently priced for the Consumer Confidence Index falling to approximately 30.

Sources: I-Net Bridge; Dismal Scientist; Plexus Asset Management.

Unemployment plays a major role in consumer confidence. (Please note the reverse scale of the unemployment rate.) Consumer confidence is unlikely to improve significantly unless employment increases drastically.

Sources: I-Net Bridge; Dismal Scientist; Plexus Asset Management.

At this stage of the economic cycle the FOMC would normally be inclined to cut the Fed fund target rate. If the FOMC had not been so dovish in the first half of last year and raised rates even slightly, it would have been in a position to cut the rate earlier this year. Now it has no room to move with the rate hovering around zero.

Sources: FRED; Plexus Asset Management.

It seems to me the FOMC has no alternative but to embark on QE3. There is a flickering of light at the end of the tunnel, though. The 12-month momentum of MZM velocity appears to have bottomed in line with that of the GDP in current money terms.

Sources: FRED; Plexus Asset Management.

The stock market is currently driven by the normalising of anxiety levels, with the S&P 500 Index slightly overpriced by approximately 3% compared to the anxiety levels as represented by the VIX and the PE10. At this stage the current process is resulting in too rich ratings that are out of line compared to the underlying economy as represented by the Conference Board’s Consumer Confidence Index. However, I do think the Consumer Confidence Index is likely to improve close to 50 in the next few months, but not quite to 60 as anticipated by the stock market. The market must therefore be anticipating a big QE3 to justify the ratings!

In sum, I am approaching the U.S. stock market with some caution at this juncture. That said, I remain bearish on U.S. long bonds as I think the U.S. economy is in a somewhat better shape than the bond market is suggesting.

“From 2000 through 2007, a remarkable run-up in global home prices occurred (see chart). But that trend has reversed abruptly. In 2008, the value of US residential real estate fell 10 percent; the global average fared only somewhat better, declining by almost 4 percent. We estimate that falling home prices erased more than $3.4 trillion of household wealth in 2008.”

The chart below reads to me as having regular cycles, oscillating within a range. But something happened in the early 2000s to have that range explode upwards.

(Please note the title is from McKinsey, I have long stated this was a credit bubble –not a housing bubble)